Amazon.com, Inc. (NASDAQ: AMZN) is an e-commerce giant. The company was launched about two decades ago, but it is still considered a growth stock given the explosive growth opportunities. Amazon’s sales have registered a CAGR of about 31 percent over the past five years. The company’s customer base falls into four sections: consumers, enterprises, content creators, and sellers.
Global e-commerce space continues to grow. People are increasingly turning to online retailers because it’s convenient and saves time. The U.S. e-commerce market is expected to jump 13 percent from last year to $262 billion in 2013. Most of the growth will come from rising sales of tablets, smartphones, and other similar devices.
However, many are skeptical of the stock because of the company’s razor-thin profit margins and lofty valuations. Let’s look at both facets of the story to figure out whether Amazon still has the potential to go up, or if it’s just a sinking boat.
Why Some Are Skeptical About Amazon?
Well, everybody raved about Amazon’s growing revenues and profits until 2011 when Kindle happened. To keep customers tied to its ecosystem, Amazon launched Kindle reader in 2011. The company began selling the device at break-even prices, and wanted to make money on content when customers bought movies, games, e-books and other content from Amazon.
However, that model didn’t work. Though revenues continued to go higher, earnings began to plummet. The company’s earnings declined from $1.37 per share to –23 cents within just two years.
For the second quarter ending June 30, Amazon reported a 22 percent increase in net sales to $15.7 billion, compared to Q2 2012. However, the company posted a $7 million net loss, compared to a $7 million profit in the same period last year.
The company’s free cash flow stood at $24 million, which is much lower than its competitors. Wal-Mart Stores, Inc. generated $3.26 billion in free cash flow for the quarter ending June 30, while the figure for Google Inc. stood at $3.094 billion. That definitely puts Amazon at risk. But what’s the reason behind Amazon’s dwindling free cash flow? That leads us to our next point.
Amazon is Positioning Itself for the Future
Amazon is spending heavily on a lot of things to thwart any future competition. Now it’s no longer just an e-commerce company. The company has broadened its scope to publishing, cloud computing, tablets, and e-readers. Instead of sitting idle, Amazon is building infrastructure, digital content, and warehouses to prepare itself for the future.
The company is implementing several changes that are likely to reduce costs in the long-term, and give it an edge over competitors:
- Amazon is spending millions of dollars to build distribution warehouses close to customers. That will save a lot of money in shipping costs. The company has started using its own delivery trucks, eliminating FedEx and UPS from some of its large network. That will be even more profitable as the membership of Amazon Prime is expected to grow from 10 million currently to about 25 million by 2017.
- Amazon has started a new initiative of delivering fresh-cut flowers in 48 states of the U.S. The company has six flower offerings, priced between $28 and $41. This is Amazon’s new way of delighting the customers. It will strengthen Amazon’s position in fresh items.
- The U.S. grocery market is estimated to be worth about $850 billion. The Jeff Bezos-led company has started the online grocery store Amazon Fresh that offers same-day and early morning delivery.
These initiatives have large upfront costs, but they are expected to generate heavy returns over the long run. A strong distribution network, established brand, efficient delivery, and competitive price will give Amazon an edge over budding online retail portals.
Amazon’s cloud computing business has been growing rapidly over the past few years. The segment registered a 22 percent growth in the first quarter of 2013. And the business is expected to keep growing as businesses seek to trim their IT infrastructure expenses.
Cloud service businesses have relatively high profit margins. Large corporations as well as young startups are flocking to Amazon’s cost-efficient services. Though Google, Microsoft, and IBM are directly competing with the company, Amazon is far ahead of them in the game. Amazon has a strong brand, and its cloud services business is known for reliability, unlimited storage provisions, and support for all languages.
And Then There Is China!
Amazon’s presence in China isn’t that strong yet. It has less than 3 percent market share in China’s e-commerce business. But the Chinese online retail market is expanding rapidly. And if Amazon maintains even its 3 percent share, that will convert into billions of dollars in sales. The Chinese e-commerce market is worth about $1.4 trillion and has expanded at an average of 71 percent annually between 2009 and 2012. China has 512 million active internet users as of 2012. That figure is expected to cross 800 million by the end of 2015. So, even if Amazon fails to increase its market share, its sales are likely to jump.
Amazon is a solid brand. The company is going in the right direction. It is leading the online retail space, and strengthening its position in the web services business. However, Amazon is temporarily facing low margins as the company implements several initiatives. The profit margins are expected to improve as one-time costs of new initiatives come down. Though the stock is trading near its all-time high, I believe Amazon still has the potential to go higher.
What are your thoughts on the future of Amazon?
Vikas is a professional financial journalist and value investor with more than four years of investing experience. Vikas spends most of his time reading investment books, writing about finance and looking for stocks that have significant growth potential.